Analysis: Anything's possible if U.S. debt downgraded to AA

NEW YORK For those who think a deeply indebted United States has begun its long, slow fade as the world's dominant financial power, the loss of the country's gold-plated AAA credit rating would seem poetic justice.

That's because characteristics blamed for volatile markets in countries like Italy -- high debt levels, slow economic growth, and government gridlock -- fairly describe the United States now.

The debt ceiling has been the chief source of market angst lately, but that's a short-term problem. The greater concern is: What happens if the United States, the risk-free benchmark from which all other assets in the global financial market are priced, loses its coveted triple-A rating?

Nobody knows for sure.

But as James Melcher, founder and president of Balestra Capital in New York, puts it, "If the impossible occurs, everything else becomes possible. It would have psychological repercussions that could be serious, and that certainly sets the stage for things to deteriorate."

It isn't a far-fetched scenario.

Standard & Poor's and Moody's Investors Service warned last week that they might cut the U.S. rating without major cuts in spending, even if politicians manage to stave off default by raising the U.S. debt ceiling.

Some fear Congress may never be able to cut the deficit or raise revenues substantially. The United States is set to run a $1.4 trillion shortfall in the fiscal year ending September 30, one of the largest as a share of output since World War II.

END OF THE LOVE AFFAIR?

The long-run cost could be great in terms of a re-pricing of U.S. assets and an erosion of the U.S. ability to finance itself cheaply in a currency that it alone can print.

Funds with big holdings of U.S. Treasury debt would probably see yields rise and prices fall, hurting returns. General U.S. government bond funds held $28.2 billion at the end of June, according to Lipper, a Thomson Reuters service.

Primary dealers use Treasuries as collateral for loans, so a downgrade could also prompt a wave of margin calls and a scurry for cash that hits the value of everything from stocks to corporate debt.

Some say the sooner markets stop their love affair with Treasuries, the better.

"Investors should wake up to the fact that U.S. government securities are not risk free," said Ron Florance, who heads investment strategy at Wells Fargo Private Bank. "We've been underweight Treasuries for a long time."

A saving grace for the United States, though, may be that when it comes to safety, alternatives to U.S. assets are few.

U.S. government debt is "still one of the prettiest horses in the glue factory, so I don't see investors migrating away to say, Swiss sovereigns, which introduces currency exposure," said Carl Kaufman, fixed-income portfolio manager at Osterweis Capital Management in San Francisco. "The market is just not deep enough."

CONSIDER THE ALTERNATIVES

What to buy instead is not an easy call.

Gold is an option for some, though pouring in now means paying record prices for an asset that generates no returns.

Douglas Borthwick, managing director at foreign exchange brokerage Faros Trading, said investors will look to invest in euros and emerging Asian currencies such as the Singapore dollar and Chinese yuan as well as more secure sovereign debt from countries such as Canada, Germany and Australia.

Foreigners were net sellers of U.S. assets in May for the first time in 11 months and more than doubled their purchases of Canadian debt that month.

Some analysts noted that Japan, which had its triple-A credit rating cut by S&P a decade ago, can still borrow at extremely low rates. Its 10-year note yields 1.07 percent, compared with 2.94 percent in the United States, 3.35 percent in AAA-rated France and 4.93 percent in AAA-rated Australia.

But the United States, unlike Japan, depends on foreigners to finance its spending. Nearly half of U.S. government debt is held overseas, with more than $1 trillion held in Beijing.

While China couldn't dump all that debt overnight, it could stop adding to it, analysts say.

Russell Napier, consultant at Hong Kong-based brokerage and investment group CLSA and author of "Anatomy of the Bear," said a steady rise in U.S. Treasury yields would end the days of U.S. companies' blockbuster earnings and could start a long decline for stocks.

STATE AND LOCAL FALLOUT

U.S. states, cities and school districts are also in the crosshairs and could be looking at downgrades of their own.

All three major ratings agencies have said the top ratings on billions of dollars of pre-refunded municipal debt secured by U.S. Treasuries could fall if the federal rating is cut. More than $130 billion in muni debt is at risk of downgrade from triple-A, Moody's said last week.

Moody's Investors Service put hundreds of bonds sold by the 15 AAA-rated states on review, including those with close ties to the federal government such as Maryland and Virginia.

Colleen Denzler, head of fixed-income strategy at Janus Funds, said that means as much as 72 percent of the Barclays U.S. Aggregate bond index could be at risk of downgrade.

Downgrades were likely to sting munis, but it was tough to say who would suffer most in a $2.9 trillion market with an unusually high share of buy-and-hold investors, said David Manges, municipal trading manager at Mellon Financial Markets.

Cadmus Hicks, managing director at Nuveen Asset Management, noted that federal aid accounted for 24 percent of state and local government receipts in the first quarter of 2011.

Craig Brandon, who helps manage Eaton Vance's $25.2 billion of municipal bond assets, said he would avoid debt issued by hospitals reliant on federal Medicaid payments and colleges that get federal student loan backing. He added, however, that he would favor bonds from publicly owned utilities and some AAA-rated states.

"But the sentiment of retail investors, that's the wild card," Brandon said. "What is the average investor who has a muni bond mutual fund going to think if the federal government is downgraded? I just don't know."

Institutions with strict investment guidelines may also be forced to unload securities that lose their AAA status, but most funds are not this stringent.

Ironically, rules issued by the U.S. Securities and Exchange Commission in January 2010 to strengthen money market funds may have the opposite effect. The rules require money funds to hold at least 30 percent of their assets in cash or Treasury securities or certain other securities.

This was done to avoid situations where a fund "broke the buck," that is, slipped under $1 in net asset value. But it could do just the opposite.

Money market funds hold $1.3 trillion in direct and indirect exposure to Treasury and agency debt, Fitch Ratings said. Redemptions may become an issue if investors rush to sell in a frenzied reaction to a downgrade, Fitch noted.

(Additional reporting by Herb Lash, Joan Gralla and Richard Leong in New York, Karen Pierog in Chicago and Michael Connor in Miami; Editing by David Gaffen and Jan Paschal)

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